ELECTRA LIMITED First Plaintiff AND THE LINES COMPANY LIMITED
[2005] NZHC 1844
•23 March 2005
IN THE HIGH COURT OF NEW ZEALAND WELLINGTON REGISTRY
CIV-2004-485-389
UNDER the Judicature Amendment Act 1972 IN THE MATTER OF the Commerce Act 1986
BETWEEN ELECTRA LIMITED
First Plaintiff
AND THE LINES COMPANY LIMITED
Second Plaintiff
AND CENTRALINES LIMITED
Third Plaintiff
AND COUNTIES POWER LIMITED
Fourth Plaintiff
AND THE COMMERCE COMMISSION
Defendant
Hearing: 30 November - 1 December 2004
Appearances: W M Wilson QC and J C Bates for the Plaintiffs
R A Dobson QC and J S McHerron for the Defendant Judgment: 23 March 2005
In accordance with r 540(4) I direct the Registrar to endorse this judgment with the delivery time of 3.45pm on 23 March 2005.
JUDGMENT OF ELLEN FRANCE J
CONTENTS
Introduction
The price path threshold Consultation
Mandatory relevant consideration? Unreasonableness
Discretion Result Costs
Para No.
[1]
[7]
[10]
[105]
[128]
[177]
[178]
[179]
Introduction
[1] The Commerce Commission, the defendant, has responsibilities under Part 4A of the Commerce Act 1986 to take steps to promote the efficient operation of markets directly related to electricity distribution. Ultimately, Part 4A provides for targeted control of services supplied by large electricity lines businesses such as the four plaintiffs. The businesses can avoid control by keeping within thresholds set by the Commission. A business will breach the 2004 threshold if its average price changes at an annual rate exceeding the change in the Consumer Price Index (CPI), less the annual rate of X percent that is set by the Commission for that business. This is the threshold which the plaintiffs challenge.
[2] The four plaintiffs are trust-owned electricity lines businesses. They distribute their surplus revenue to their owners by way of rebates in contrast to, for example, shareholder-owned businesses which distribute profits as dividends to their owners. Rebates are treated as a pre-tax deduction, dividends are not.
[3] The plaintiffs challenge the methodology adopted by the Commission in setting the thresholds which applied from 1 April 2004. In particular, the plaintiffs challenge the Commission’s decision to include in the methodology the post-tax revenue from their businesses without at the same time making any allowance for the tax notionally payable on those rebates.
[4]The plaintiffs’ arguments are summarised as follows:
a)The notional tax is a relevant consideration in assessing post-tax profit;
b)The point is so obvious that to conclude otherwise is irrational in the administrative law sense;
c)Alternatively, the Commission did not consult with the plaintiffs at all, let alone consult meaningfully, as to the tax treatment of rebates.
[5] The Commission says that its approach is a reasonable one and it has consulted with the plaintiffs on these matters.
[6] There are three causes of action, the first alleging flaws in the Commission’s consultation process leading up to the decisions on the threshold; the second a failure to have regard to relevant considerations; and the third based on unreasonableness.
The price path threshold
[7] The threshold set by the Commission which is the subject of this challenge is termed a price path threshold. The purpose of the threshold is described by the chairperson of the Commission, Paula Rebstock, as providing incentives for large electricity lines businesses to improve efficiency, to share the benefits of efficiency gains with consumers over the long-term, including through lower prices (in real terms), and to be limited in their ability to extract excessive profit.
[8] As Ms Rebstock explains, the price path threshold is of the form CPI - X. This formula represents the difference between the rate of the CPI and a percentage figure described as the “X factor”. The X factor percentage is a number between minus one and two. Each distribution business is assigned an appropriate X factor, as set out in Schedule 1 to the Commerce Act (Electricity Distribution Thresholds) Notice 2004.
[9] The X factor is the sum of three parts. First, the B factor (common to all large electricity lines businesses) representing expected annual industry-wide efficiency gains over the five year regulatory period determined through Total Factor Productivity analysis (TFP). Second, the C1 factor which, as Craig Rice the expert adviser to the plaintiffs says, is derived for each large electricity lines business (but not Transpower) to reflect expected annual productivity gains for each business relative to its peers. The third component of the X factor is known as the C2 factor. The C2 factor represents the relative profitability of distribution businesses and is based on an analysis of the residual rate of return of businesses. In its initial, 5 September 2003 paper, the Commission proposed that the residual rate of return be determined on a pre-tax basis. In its December 2003 paper, that changed to a post- tax basis. Ms Rebstock says that the change was made to improve the comparability between businesses with different ownership structures and so to better reflect relative profitability.
Consultation
[10] The Commission has a statutory obligation to consult in terms of s 57G(a) of the Commerce Act 1986. That requirement was absent from the original bill. Section 57G states as soon as practicable after the commencement of this Subpart the Commission must, and may from time to time⎯
(a) consult with participants in the electricity distribution and transmission markets and with consumers as to possible thresholds for the declaration of control in relation to large electricity lines businesses; and
(b) set thresholds for the declaration of control in relation to large electricity lines businesses; and
(c) publish those thresholds in the Gazette, on the Internet, and in any other manner (if any) that the Commission considers appropriate.
(i)The pleadings
[11] In terms of the consultation process, it is alleged that the Commission’s consultation process is flawed. That allegation is based on the Commission’s failure to notify the plaintiffs of its intention to revise the “C2” factor by deriving it from post-tax residual rates of return. Further, it is said the Commission did not provide the plaintiffs with any or adequate opportunity to comment upon these changes and nor to provide evidence about the errors and relevant considerations upon which the revisions were based.
[12] The plaintiffs say that if they had been given the chance to comment on these revisions, they would have been able to provide evidence that ought to have satisfied the Commission that its change in the derivation of the “C2” factor from a pre-tax to post-tax residual rate of return should incorporate the tax shield provided by customer rebates.
[13] The other alleged breach of obligations of consultation and fairness relates to the defendant’s failure to provide the plaintiffs with a copy of the final Meyrick report for their consideration before reaching the final decision. Meyrick & Associates were engaged by the Commission to assist with work on the quantitative basis for deriving a comparative approach for allocating distribution businesses to different groups.
[14] In terms of this cause of action, the Commission denies the claim and says further:
a)The Commission’s consultation process was sufficient and appropriate relative to the nature of the decision.
b)The possibility of a change from pre-tax to post-tax residual rates of return was foreseeable given that the issue of tax treatment was raised before and during consultation on the draft decisions paper.
c)Comments from the plaintiffs were received in the post-decision consideration as to how the decision would be promulgated in a Gazette notice, and considered.
[15] The Commission also says that the plaintiffs each commented on changes between the draft decisions paper and the final paper. The Commission considered those comments in the process of finalising the Commerce Act (Electricity Distribution Thresholds) Notice 2004, and in considering changes to the final decisions paper when it was re-issued on publication of the final Gazette notice.
[16] The Commission admits that it did not provide the plaintiffs with a copy of the Meyrick report until after the release of the final decisions paper on 23 December 2003.
(ii)Submissions
[17] The plaintiffs’ criticism is that the Commission itself did not raise the prospect of moving to a post-tax analysis, and without including an adjustment for the tax effect of rebates. The consultation process had not led to any industry support or consensus as the Commission had initially sought. Instead, the Commission decided, after the consultation process, to rely on the report from Meyrick & Associates without reference to the plaintiffs or any other industry shareholder. The Meyrick report advocated a post-tax analysis.
[18] The plaintiffs argue there was nothing in the consultation process to alert them to the possibility the Commission might change to a post-tax analysis without taking account of the tax effect of rebates. It is also submitted there was no opportunity to comment further on the cross-submissions. Hence, by the time the intention to alter the methodology was clear, the Commission’s 23 December paper represented a concluded decision. Accordingly, the opportunity to comment on the Gazette notice did not equate to any willingness to amend the methodology adopted by the Commission. The Commission had by that stage closed its mind to any substantive debate on this issue.
[19] The question of adjustment of the tax effect of rebates is a significant one for the plaintiffs. The plaintiffs should have been given the opportunity to make specific submissions on such a material change.
[20] The Commission maintains that if there was any requirement to consult specifically on this aspect, it met any legal obligation by the discussion which occurred subsequently. At that point, the Commission maintained an open mind on the post-tax rate of return methodology. In any event, this was an issue plainly on the table after the September conference and it was for the plaintiffs to take the initiative and raise the matter.
[21] At the time of the conference, all interested parties were on notice that there might be further upward changes to the components of the X factor. Importantly, in the course of the consultation process, the limits of pre-tax comparisons were commented on. This led implicitly to a consideration of post-tax comparisons, as an alternative. In that context and given the wide-ranging nature of the process where, as Mr Dobson for the Commission put it, “everything was on”, it was reasonable for the Commission to expect the parties to “grasp the mettle”.
[22] The Commission says it is not possible to have endless reiterations. The new threshold came into effect in April 2004 and it is sensible commercial practice for parties to know the rules some time in advance. Indeed, the Commission can change its view or refine its position without being required to test that change or refinement on interested persons.
[23] As a further argument, the Commission says that this aspect was not so significant as to require specific consultation. Here, the Commission emphasises this part of the methodology was “a part of the jigsaw” that cannot sustain the separate importance the plaintiffs claim for it. The Commission also points out that the fundamental aspects of the thresholds remained and indeed the other changes, especially to the B factor, improved the plaintiffs’ positions overall.
(iii)The consultation process
[24] It is necessary to consider in some detail the consultation undertaken by the Commission over a two year period. This involves the first or initial setting of thresholds (which is not challenged) and then the resetting of those thresholds which is what is in issue. The defendant’s counsel prepared a very helpful summary of this consultation process which is reproduced as Appendix A.
[25] The starting point is the discussion paper released by the Commission on 21 March 2002 - “Regulation of Electricity Lines Businesses”. This paper set out the framework the Commission was using to interpret the Purpose Statement in s 56E of the Act, proposed options for thresholds, and factors the Commission would take into account in deciding which option to adopt and its preferred approach to price control.
[26]There were four broad options set out, namely:
a)Option 1 – the setting of efficiency and quality thresholds only;
b)Option 2 – the setting of efficiency, sharing and quality thresholds only;
c)Option 3 – the setting of all thresholds, that is, efficiency, profit, sharing and quality; and
d)Option 4 – the setting of all thresholds but the efficiency threshold would be linked to benchmarking, that is, it would not include a price path criterion.
[27] The Commission sought and received submissions on this paper. There was then a lines business conference hosted by the Commission in July/August 2002. Post-conference submissions were invited and received.
[28] On 23 December 2002, the Commission released a draft decisions paper. In this paper, the Commission said it intended to set three thresholds with effect from 1 April 2003 – 31 March 2008:
a)A price path threshold;
b)A quality threshold; and
c)An excessive profit threshold.
[29] The paper recorded that a lines business would breach the price path threshold if its prices, on average, were to rise in any year by more than the Consumer Price Index (CPI) less an efficiency factor (X).
[30] The next step in the initial setting of thresholds was the release of a further draft decisions paper on 31 January 2003.
[31] This paper modified the 23 December draft decisions paper. The paper indicated that the Commission proposed to apply the price path threshold to prices before rebates, line charge holidays, or discounts were subtracted (i.e. for present purposes, pre-tax). The paper said this would mean such lines businesses were treated in the same manner as other lines businesses not using instruments like rebates and line charge holidays.
[32] At this point also, the Commission introduced the concept of categorising lines businesses in three categories with the categories based on a comparative analysis of the business performance. The paper also noted an issue arising out of the different approaches to ownership of lines companies, as follows:
In regard to the definition of average price, the Commission considers it necessary to normalise this measure for lines businesses owned by consumer trusts. Some of these businesses provide rebates and discounts to consumers as compensation for their ownership interest. Others simply post lower tariffs, and in this case consumers receive “implicit rebates” as compensation for their ownership interest. The Commission proposes to account for rebates and discounts in the price path so that lines businesses owned by consumer trusts are treated consistently with other businesses. (at 3)
[33] Submissions were again invited and received on both the December 2002 and January 2003 papers. Interested parties in addition had the opportunity of presenting submissions at a five day conference hosted by the Commission in March 2003. Cross-submissions following the conference were invited and received.
[34] 31 March 2003 saw the Commission publicly announce the decision to set a price path threshold and a quality threshold. The media release explained that a paper setting out the decisions would be released as soon as possible. At that stage also the Commission indicated it would reset the price path threshold to apply from 1 April 2004 with the intention that it be set for five years.
[35] The next step took place on 2 May 2003 and this saw the release of the Commission’s paper dealing with “threshold” decisions.
[36] At the same time a draft of a Gazette notice was also provided. Two thresholds were set in the draft, one CPI – X, a price path threshold; and the other a quality threshold. The paper noted that initially X = CPI until 31 March 2004 when the price path threshold would be reset. The concept of a profit threshold was rejected. Again, the paper signalled possible differences as between different lines businesses and different methodologies. In particular, the paper noted that the Commission would develop and review various methodologies to apply from 2004 and would consult during 2003.
[37]As to the purpose of the price path threshold, the paper stated:
The purpose of the price path threshold is to provide incentives for lines businesses to reduce their prices in real terms. The threshold, therefore, ensures that such businesses face strong incentives to improve efficiency; limits the ability of lines businesses to extract excessive profits; and ensures that the benefits of efficiency gains are shared with consumers, including through lower prices. (at 2)
[38] Submissions were received on the draft Gazette notice. The initial thresholds were gazetted via the Commerce Act (Electricity Lines Thresholds) Notice 2003. In addition, on 6 June 2003 the Commission released its 2003 decisions paper.
[39] The decisions paper updated the 2 May 2003 paper to reflect the technical amendments made to the draft Gazette notice and to provide some clarification.
[40] Prior to the release of the formal initial thresholds, the Commission started the process of resetting the thresholds. This began with the release of a discussion paper (30 May 2003) and of the Ministry of Economic Development (MED) data sets. (Prior to the introduction of Part 4A to the Commerce Act in 2001, the Ministry of Economic Development had a role in relation to the regulation of the electricity business. The MED data sets comprised lines business reliability and systems statistics (pursuant to the Electricity (Information Disclosure) Regulations 1994) and lines businesses financial information disclosed under the 1999 Regulations.)
[41] The 30 May discussion paper set out the following options for resetting the price path threshold:
a)A preferred comparative option in which X = B + C with the B factor reflecting industry wide improvements in efficiency, and the C factor reflecting relative price efficiency and possibly the quality of business output.
b)A partial building blocks option in which X = B + D + E. (D would realign prices to costs and E would be based on a price/quality trade- off.)
[42] This paper proposed the retention of the basic CPI – X formula for the price path threshold with the addition of a comparative option whereby the X factor comprised two component factors, namely,
a)A “B” factor reflecting industry wide improvements in distribution business efficiency (productivity); and
b)A “C” factor reflecting the relative performance of distribution businesses, after normalising for costs drivers beyond the control of management.
[43] The B factor would be determined through Total Factor Productivity (TFP) analysis and would apply equally to all distribution businesses. Dr Gunn on behalf of the Commission explains that the B factor represents an attempt to emulate the outcomes of competitive markets.
[44] The C factor would encompass matters of relative business productivity, profitability and service quality. Dr Gunn noted that those businesses with unfavourable prices or quality relative to their peers would be expected to reduce their prices or improve quality in the future more quickly than other distribution businesses.
[45] The discussion paper outlined criteria for evaluating possible methodologies for resetting the price path threshold. These included the following implementation criteria:
methodologically robust, replicable and transparent, to the extent appropriate for a threshold, rather than control .. Takes account, where practicable, of industry-specific factors, such as the use of discounts by trust-owned lines businesses
[46] The Commission asked for submissions on the question of the robustness of the methodology to be used to reset the price path threshold.
[47] The discussion paper outlined some of the issues associated with comparing lines businesses that provided rebates to consumers with those lines businesses that do not. For instance:
4.150Consumer trust - and cooperatively-owned lines businesses use rebates, line charge holidays and discounts as a means of returning dividends to owners of the network, who typically are also the consumers of the services provided by the network. These lines businesses generally pay only a small dividend to the trust or cooperative to cover administration costs. The rest of the funds are distributed directly to the consumer owners through rebates etc.
4.151Some lines businesses make rebates, discounts and line charge holidays explicit through lump sums paid to consumers but others have lower prices, thus earning a rate of return below their cost of capital. Some other lines businesses with different ownership structures may also earn a rate of return below their cost of capital in some years.
4.152To enable a comparison of the relative efficiency of lines businesses, it might be necessary to adjust revenues (or prices) for the under-recovery of the cost of capital by trust and other lines businesses. A possible approach was suggested by Dunedin Electricity.
[48] Again, there was particular focus on issues raised by the trust-owned companies.
[49] The issue of the effect of different ownership structures was also a matter raised in submissions on the May 2003 paper.
[50] Benchmark Economics, in their submission of June 2003 on behalf of Powerco, referred to the difficulties in determining efficiencies of price given the different financial structures. In consumer owned businesses, returns to shareholders are less apparent as they are in the form of discounts, or rebates, rather than profit. The submission continued:
The lack of a commercial return or tax payments in the disclosed revenues for these businesses means the disclosure data does not present a viable database for quantitative assessment (para 2.5.4)
[51] In its submission of 30 June 2003 on behalf of 17 large electricity lines businesses including three of the plaintiffs, PricewaterhouseCoopers (PwC) stated:
Entities who may have chosen to pass on lower prices to consumers by way of a discount or rebate should be assigned a higher C factor than those with lower posted prices (assuming all other things are equal). These entities have the ability to reduce posted prices (and the value of the discount paid or rebate if necessary) without compromising their owners’ pricing objectives or financial viability.
Alternatively, entities who may have chosen to post higher prices, and return profits to shareholders by way of a dividend, should also be assigned higher C factors (all other things being equal) than those with lower posted prices. The objectives of the Purpose Statement are met as incentives for lower prices for consumers are introduced, and incentives exist for improved efficiency should the owners wish to maintain the level of returns achieved.
Thus no normalisation for perceived under recovery of ELBs [Electricity lines businesses] is required. If an ELB is unable to sustain the low prices it has in place over the medium term without breaching a price path threshold, it has the opportunity to defend a breach during the price control investigation. These principles apply irrespective of the ownership arrangements, subject to our concerns about retailer behaviour outlined
above. Thus it is not necessary for specific provisions to be made for trust owned entities for example in determining the price path threshold. (at 27)
[52] As part of Powerco’s submission, Harding Katz (a consulting practice specialising in regulatory economics) submitted that on a building-blocks approach, the “D” factor should be set so that:
.. (iv) existing profitability is defined as the after-tax rate of return earned by the lines business using either the most recent year’s disclosure data or the average of the previous year’s disclosure data ...
(vi) The tax cost included in the calculation of existing profitability must be the notional tax payable as stated in the disclosure data; ..
(ix) measures of profitability of trust-owned businesses should incorporate appropriate adjustments for discounts, rebates, and the effects of any other policies that are not consistent with the targeting of a normal commercial return on investment; .. (at 27-28)
[53] PwC also submitted, in response to questions asked by the Commission on tax treatment, that:
Tax should be accounted for as a cashflow item, after allowing for the notional add-back for the interest tax shield, with a post-tax WACC [i.e. weighted averaged cost of capital] used to calculate the return on the RAB [i.e. regulated asset value]. For the purposes of determining taxation for normalising the starting position of each ELB (for use in a threshold screening mechanism), normalisation of the tax base on the formula proposed under 5.14 and 5.24 [of the 30 May 2003 discussion paper] would be an acceptable approach. However, these formulae appear to suggest that notional tax should be calculated after allowing for interest expense tax deductions. This is not correct, if a WACC is being applied to the RAB then to be consistent a notional tax should be calculated in the absence of interest expense tax deductions (since the interest tax shields are already allowed for in the WACC).
[54] There were also some comments on the difference between structures in the context of submissions on the MED data sets.
[55] Benchmark Economics referred to the fact that the current mix of commercial and non-commercial structures among the lines businesses created a data set that was not directly comparable. If efficiency is to be estimated by comparing average revenues, or similar, then Benchmark said it will be necessary “to construct a dataset with greater commonality of those revenue streams.”
[56] Benchmark’s view was that in the context of adjustment of revenue, most focus was on normalisation of the rate of return. Benchmark considered this was too restrictive. Differing rates of return are just one manifestation of the varying structures.
[57] Benchmark noted that explicit and implicit discounts paid by trust and other type structures were “the equivalent of dividends paid to shareholders in lines businesses with corporate structures” and as such they should be included in the adjustment.
[58] Finally, Benchmark noted that tax is part of the “cost” of operating a business and would normally be included in network “costs”. However, the lack of taxable profit in a number of lines businesses means “there is no standard pattern of tax payments across the networks. To avoid the additional complexity of inferring taxation payable on inferred rates of return,” Benchmark thought it would be simpler to remove taxation payments from the comparative analysis. If tax was to be included it should be notional tax payable.
[59] Orion’s submission dated 8 July 2003 on the MED data sets raised these tax issues:
Rebates to customers are problematic .. The ability of trust-owned companies to provide a tax-deductible rebate from pre-tax earnings does not allow meaningful comparisons to be made with companies who provide a return from post-tax earnings by way of a dividend .. ROI’s and other performance measures should be adjusted for this treatment to ensure like- with-like comparisons. (at 4)
[60] On 27 August 2003, Commission staff met with industry representatives. Craig Rice of PwC attended on behalf of three of the plaintiffs and Margaret Beardow from Benchmark Economics was there as well to present a joint supply submission from the first, second and fourth plaintiffs, and Aurora, Network Tasman, Powerco and Vector (comprising some 80 percent of the markets). This comment was made:
Note some consumer trust-owned entities:
·Report discounts and rebates – these should be added back for comparison purposes
·Under-price their services for tax and other reasons – these implicit discounts should also be adjusted for if a method can be developed for doing so
[61] On 5 September 2003, the Commission released its draft decisions paper along with the report from Meyrick & Associates. In this paper, the Commission set out the methodology it proposed to use to set the X factor.
[62] A comparative approach to setting the X-factors was preferred over a partial building blocks approach. The latter was seen as making “explicit” adjustments to bring prices in line with costs so possibly reducing the incentives to achieve more efficiencies. Further, the Commission said that its final decisions would use 2003 data.
[63] Distribution businesses whose average price changes at an annual rate exceeded the change in CPI, less the annual rate of X percent set by the Commission for that business, would breach the threshold. The higher an assigned C factor, the higher the X factor and the lower the price able to be charged to avoid breach.
[64] In terms of the B factor, the Commission proposed an indicative value for B of 2.6 percent. Calculation of this factor used TFP analysis and MED data from 1996 to 2002.
[65] It was at this point that there was a split in the C factor. The C factor was to comprise two components:
a)A relative productivity or cost efficiency component factor to be determined by ranking distribution businesses by their multilateral total factor productivity index – allowing comparisons both of productivity growth rates and the absolute levels of productivity into above average, average, and below average performers; and
b)A relative profitability component factor determined by ranking distribution businesses by their residual rates of return.
[66] The draft paper proposed assigning C factors of –1 percent, 0 percent or 1 percent to three groups. Businesses performing near the industry average in terms of their relative productivity and profitability would receive a factor of 0. Those businesses achieving higher productivity levels, taking their density characteristics into account, and/or low rates of return would be assigned a C factor of –1 percent. Businesses achieving low productivity levels and/or high rates of return would be set a positive C factor of 1 percent.
[67] Accordingly, if the relative rate of return of a lines business was higher than its peers it was more likely to be assigned a higher C factor. A higher C factor in the price path threshold calculation CPI – X meant that prices charged would need to be lower. The relevant part of the methodology at this point reflected pre-tax figures. Similarly, the Meyrick report ranked the relative distribution businesses’ profitability by examining average residual rates of return as a pre-tax measure.
[68] The Commission extended the deadlines for submissions and comments on the draft paper and a conference was scheduled to be held in early November.
[69] On 11 September 2003, there was a meeting between Commission staff and Powerco and its adviser, Margaret Beardow, from Benchmark Economics. Benchmark Economics in its presentation addressed the argument that rebates and discounts obscure the true price, costs, and profitability, making price and cost comparisons problematic. Hence, Ms Beardow suggested it would be necessary to “normalise” revenue to account for all discounts etc to develop a common base for analysis.
[70] Submissions were received on the September 2003 paper. They included one from PwC which included the following points:
a)It was not necessary for specific provisions to be made for trust owned entities.
b)PwC anticipated the possibility that the Commission might increase the X factor.
[71] Orion was critical of the C2 factor and the approach to calculating residual rates of return emphasising also problems with the data being used. Benchmark Economics’ submission on behalf of Powerco also discussed the methodology used to determine profitability and recommended a post-tax approach for deciding the residual rate of return. Benchmark’s submission of 20 October 2003 also noted the impact of the differing ownership models.
[72] The next step was the thresholds conference, an open public forum, held on 3 to 6 November 2003. The discussions at that conference were transcribed and the transcripts available on the Commission’s website. There was discussion about the setting of the C2 factor which encompassed debate about the residual rate of return approach and about the appropriate approach to be taken to different ownership structures.
[73]Following the conference, various groups made cross-submissions.
[74] The submission from Charles River Associates (advisers for Vector) recommended that if the Commission were to impose C2 factors, the taxation implications of different means of providing bonus for benefits should be taken into account so like with like comparisons could be made.
[75] Both Powerco and Orion in their submissions took from the discussion a recommendation that if a C2 factor were to be included, it should be undertaken on a post-tax basis. Orion, in its cross-submission, recognised that Meyrick’s adjusted Return on Investment (ROI) approach in the draft decisions was a post-tax measure. Orion’s key concerns included:
•the erroneous C2 which arises from the inappropriate use of pre-tax ROIs instead of post-tax ROIs ..
[76]Under the heading “Other clarifications” Orion also said:
Further, we note that the [Meyrick] residual rate of return measure is pre- tax, but it is compared with the adjusted ROI measure which is post-tax. This causes a distortion which treats some companies in an unfair and erroneous manner.
[77] Orion’s cross-submission included a report from NERA (National Economic Research Associates) which focused on the definition of economic profit. Dr Gunn, on behalf of the Commission, says that this was the only submission from any interested party to recommend a specific approach to calculating rates of return in the context of deriving a C2 factor. NERA’s report explained that the “basic” method for defining economic profit included revenue, depreciation, operating costs, tax and the regulated asset value, but noted that “there is inevitably room to debate the individual elements”. NERA’s report noted that another key challenge was the appropriate treatment of taxation and referred to an earlier submission by Orion which had argued that tax should be compliant with GAAP (Generally Accepted Accounting Principles), “adjusted as necessary to add back the tax effect of interest expenditure.”
[78] Powerco in its cross-submission suggested that a pre-tax measure would be likely to cause dividend paying lines businesses to consider themselves to be disadvantaged:
C2 Profitability. The inclusion of tax in the profit measure is misleading. For those businesses with typical commercial structures and tax obligations, the residual will include such tax amounts. However, those lines businesses providing explicit and implicit discounts will enjoy lower residual “profits” simply because of the absence of the provision for tax. Imposing revenue reductions on a lines businesses on the basis of its financial structure, not its actual rate of return on investment, does not seem to accord with the intention of the Comparative Option. (at 7)
[79] On 23 December 2003, the Commission published a paper entitled “Regulation of Electricity Lines Businesses Targeted Control Regime Threshold Decisions (Regulatory Period beginning 2004)”. The paper notes it is “subject to finalisation of technical detail following comments from interested parties on the draft Gazette notice”.
[80]The 23 December paper made the comparison on a post-tax basis.
[81] Dr Gunn lists the other changes made from the September through to the December reports and they include:
a)2003 disclosure data was used;
b)The definition of deemed revenue was corrected and “other” revenue was excluded;
c)Multiple corrections and adjustments were made to the disclosure database;
d)There were a number of changes in the methodology used to derive the B factor, and a reduction in the magnitude of the B factor from an implied level of 2.6 percent to 1 percent;
e)The C1 factor was based on average productivity scores over five years rather than one year, and fewer businesses were allocated to the low productivity group;
f)The approach to determining capacity output was changed, which impacted both the B and C1 factor analysis; and
g)The cap of plus or minus 1 percent on the C factor was removed, which meant that there were four groups of X factors overall, with some businesses able to increase prices in real terms without breaching the price path threshold.
[82] Meyrick’s updated report of 19 December 2003 was issued with the Commission’s 23 December 2003 paper.
[83] Dr Gunn for the Commission, and Mr Anderson from the Lines Company, then describe the dialogue which followed.
[84] Dr Gunn had a telephone discussion with Mr Anderson in the course of which Mr Anderson said he thought the 23 December paper and Meyrick’s analysis had neglected to account for the tax effect of rebates and this had unfairly disadvantaged the Lines Company.
[85] Mr Anderson asked Dr Gunn whether the 23 December decisions were final. Dr Gunn says he said they were subject to finalisation of technical detail during
consultation on the draft Gazette notices as was the Commission’s 2 May decisions paper for the initial threshold. Dr Gunn says that he told Mr Anderson that if he felt there were errors in the methodology or the data or if he felt disadvantaged by the decision, he was welcome to write to the Chair of the Commission to express his concerns and that he could support any position with calculations.
[86] A similar approach was taken by Robin Wilson who was at that time an adviser at the Commission. He spoke by telephone with John Yeoman, Chief Executive of Electra and also spoke to Mr Anderson. When asked if the decisions were final, Mr Wilson says he told Mr Yeoman they were but that the Commission “would reconsider them if they were affected by an error.” He asked Mr Yeoman to put his concerns in writing so that the Commission could consider them.
[87] Dr Gunn explains that the Commission then received letters from the Lines Company (6 January 2004); Counties Power Limited (7 January 2004); Electra Limited (14 January 2004); and Centralines Limited. The letter of 14 January 2004 from Electra was critical of the consultation process and referred to what Electra described as “errors” in the after-tax calculation.
[88] In this correspondence, different approaches to calculating the C2 factor were proposed and these are summarised by Dr Gunn as follows:
a)All plaintiffs advocated a universal tax rate approach which would likely result in all of the plaintiffs being assigned lower C2 and X factors but would, Dr Gunn says, impact on other businesses.
b)The Lines Company and Counties Power advocated a discount tax shield approach similar to that described by Mr Rice which would involve changing the C factors and therefore the X factors of some or all of the plaintiffs, and potentially other businesses.
c)Counties Power indicated that to be consistent, the residual rate of return calculations could be calculated on a post-rebate rather than pre-rebate basis.
[89] Dr Gunn explains that responses were sent to all four plaintiffs on 12 February 2004. The responses were approved by the Commission’s chairperson before they were sent. In the letter to Electra, Gareth Wilson of the Commission explained its view that the choice between returning the benefits of any efficiency gains to consumers through higher rebates, as opposed to lower posted prices, “will not typically be efficiency neutral.” Further Mr Wilson said that to finalise its decisions:
.. the Commission had to exercise its judgement concerning many aspects of determining and assigning X factors .., while fully considering the various views of interested parties. With respect to residual rates of return, the appropriate approach to calculating the tax adjustment is only one of many issues that the Commission had to consider. The Commission recognises that different approaches to calculating the tax adjustment .. could result in particular businesses considering themselves to be disadvantaged in comparative or absolute terms. The Commission balanced these various factors in the context of the Purpose Statement and the principle that the CPI
– X price path operate as a threshold rather than as a form of control.
[90] In thanking Electra for the letter, the Commission recorded that it “looks forward” to the participation of Electra in the consultation process on matters of technical detail associated with the Gazette notice to be used to give effect to the threshold.
[91] Mr Anderson wrote again on 12 February 2004 responding to the Commission’s letter.
[92] On 17 February 2004, Gareth Wilson and Dr Gunn met with Ken Sutherland of Centralines. At the meeting, there was a discussion about the Commission’s approach to determining residual rates of return. At a further meeting on 17 February, Commission staff met with John Anderson and Peter Browne both from the Lines Company.
[93] At the end of that meeting, Mr Anderson was invited to write to the Commission to explain his assertions about the “perverse” incentives he claimed were caused as a result of the Commission’s methodology. Dr Gunn says that he and Mr Wilson considered Mr Anderson’s 20 February letter and agreed it did not address any new points that warranted the Commission amending its 23 December
2003 decision. Commission staff also met with Electra representatives, John Yeoman and Rachael Hughes, on 18 February 2004.
[94] On 23 February 2004, the Commission received a letter from Quigg Partners acting for the four plaintiffs. That letter stated that the Commission’s response to date had not addressed the plaintiffs’ concerns. It reiterated the concern about consultation and said the plaintiffs took issue with the methodology used to calculate the profitability factor in the price path threshold. The letter suggested that the Commission’s approach was contrary to the purposes of Part 4A because it led to inequities as between companies.
[95] The letter concluded that Quigg Partners had instructions to proceed with judicial review proceedings.
[96] The Commission responded to Quigg Partners on 27 February 2004. The Commission’s letter stated that a number of the comments made by Quigg Partners were based on a misunderstanding and required correction. For example, the Commission said it did not accept its approach reflected an error. Nor did the Commission accept that the plaintiffs had been denied a proper opportunity to be consulted noting that the methodology for the C factor was only one of a number of issues raised as part of the consultation process. Nor did the Commission accept the view implicit in Quigg Partners’ letter that the plaintiff companies would suffer adverse consequences.
[97] A draft Gazette notice for distribution businesses was issued for consultation on 11 February 2004. There were 12 submissions on the draft Gazette notice.
[98] On 31 March 2004, the Commerce Act (Electricity Distribution Thresholds) Notice 2004 was published in the Gazette.
(iv)Discussion
[99] There is no real dispute between the parties as to the applicable principles. Where, as here, there is a statutory requirement to consult then what is required will
depend on the circumstances. There will need to be a reasonable opportunity for an exchange of views.
[100] Both parties rely on Wellington International Airport Ltd v Air New Zealand Ltd [1993] 1 NZLR 671 where McKay J delivering the judgment of the Court of Appeal referred to the principles set out in Port Louis Corporation v Attorney- General of Mauritius [1965] AC 1111, at 1124. McKay J continued:
We do not think “consultation” can be equated with “negotiation”. The word “negotiation” implies a process which has as its object arriving at agreement. There is no such requirement in the present case. The airport company is given the power to fix charges. Before doing so it must consult, and for consultation to be meaningful, there must be made available to the other party sufficient information to enable it to be adequately informed so as to be able to make intelligent and useful responses. The process is quite different from negotiation, however. One cannot expand the statutory requirement by replacing the word “consultation” with “negotiation” and then importing into the section the very different meaning of the latter word. (at 676)
[101] The Commission also refers to the principles described as applicable to a statutory requirement for consultation in Hamilton City v Electricity Distribution Commission [1972] NZLR 605. They are that a consultor who is required by a statutory provision to consult:
a)Must give the consultees a reasonable opportunity of stating their views;
b)Must provide reasonable information to the consultees;
c)Must treat the consultation as more than a formality; but
d)May still act if consultees do not avail themselves of the opportunity.
[102] Where the parties differ is as to the extent to which there was an initiative on the plaintiffs to raise the tax treatment of rebates; the significance of the decision in issue; and the effect of what occurred after the formal consultation process had ended.
[103] I consider the consultation process was adequate to meet the statutory requirement to consult. I say that for the following reasons:
a)The consultation process was open and wide-ranging. It was not the sort of process in which, as Mr Dobson for the Commission put it, those being consulted could expect to be given some sort of “checklist” of issues. The opportunity to comment was there.
b)Once the Commission moved to an approach based on relativities as between lines businesses the shift to a post-tax analysis which ignored notional tax was not such a change as to require the Commission to specifically raise it. The intention of achieving greater comparability as between businesses and so the need for normalisation as between businesses was a consistent theme.
c)The fundamental elements of the thresholds remained constant, that is, a price path with a CPI – X formula the purpose of which was to act as a screening mechanism to identify lines businesses whose performance may require further investigation and, if necessary, control by the Commission. The X factor maintained the same basic elements i.e. a C2 factor determined on a comparative approach.
d)That this particular issue was not one necessitating some specific “flag” is reflected in the fact some of those being consulted did raise the pre-tax/post-tax issue. The Powerco cross-submission is a clear illustration of the issue being “on the table”. Hence, Mr Rice in his evidence on behalf of the plaintiffs accepts there was discussion at the Commission’s conference on whether a pre-tax or post-tax residual rate of return analysis was appropriate but says that discussion was “limited”. He also acknowledges that following the conference, cross-submissions addressed the issue but points out that no interested party made a submission which now reflects the Commission’s preferred approach. That caveat is accurate but it is still the case that the issue was a live one.
e)There are difficulties, in the context of considering the adequacy of consultation, in separating out one aspect of the Commission’s methodology. This is another way of saying that this part of the formula was not so distinct or important as to warrant specific mention. That is the case because the overall position of the plaintiffs was improved. What occurred here did not equate to a “new rule” as discussed in McInnes v Minister of Transport [2001] 3 NZLR 11. This aspect is also relevant in determining how many iterations the Commission had to go through. At some point, and I believe that point had been reached, the Commission has to be able to say, “enough”, and move on and make a decision. Although I do not attach a great deal of weight to it in this context, it is also of some relevance in assessing the number of iterations the Commission must go through that the Commission has, from the outset, seen the thresholds as a screening mechanism. They are a mechanism to trigger further inquiry, not necessarily leading to control.
f)Finally, while the overall focus of the subsequent discussion was narrower with an emphasis on technical matters, I do not consider the Commission had a closed mind to the plaintiffs on this issue. They did meet with the plaintiffs and the Commission did make some changes, albeit on another aspect where an error was shown to have been made.
[104] Accordingly, for these reasons the plaintiffs have not succeeded on this part of their claim.
Mandatory relevant consideration?
(i)Pleadings
[105] With respect to the second cause of action, the failure to have regard to relevant considerations, it is said that the Commission failed to take into account that
if a post-tax approach is to be adopted for the purposes of deriving the “C2” component of the “X” factor, the Commission must correct the tax adjustment in the formula to recognise the tax shield provided by customer rebates.
[106] It is also pleaded that the Commission’s omission to consider the taxation treatment of customer rebates leads to an overstatement of rate of return, and therefore disadvantages any electricity lines business that uses this method of setting prices for customers. What this means is that the “C2” factors do not correctly reflect the post-tax, pre-rebate (or pre-discount) methodology adopted for the purposes of deriving the “X” factor.
[107]This claim is denied by the Commission.
(ii)Argument
[108] The plaintiffs’ argument is that if the Commission is making a post-tax assessment, the tax payable is a relevant consideration, indeed, a mandatory relevant consideration.
[109] In support of this submission, the plaintiffs rely on the evidence of Mr Rice who says that this is standard corporate finance practice. That evidence, the plaintiffs emphasise, is unchallenged. The Commission was wrong to do other than follow standard practice.
[110] In response on this ground, the Commission points to the open-textured statutory provision. There are no express criteria for the Commission to consider and so it is necessary for the plaintiffs to discern from the purpose provision and the more general context of the threshold regime that the mandatory relevant consideration they contend for is present.
[111] The Commission submits that it is left to the Commission to determine how it forms the thresholds but it is expected to apply a regulatory framework to that exercise. In order to succeed, the plaintiffs have to show that Mr Rice’s view is the only available one and, the Commission says, they do not “get there” on the facts.
[112] Once the Commission decided that a comparative profitability factor ought desirably to form part of the threshold, it was relevant to consider the best mode of doing that. The Commission would resist any greater particularity about what is relevant to it than that. On the facts, the Commission has formed the view that a comparative profitability factor is usefully included and it has exercised its discretion as to the form that should take.
[113] Finally, the Commission submits that there are many ways in which this part of the equation could have been implemented. The position contended for by the plaintiffs is not mandatory and in any event, the Commission did consider various options.
(iii)Discussion
[114] Any mandatory relevant consideration must, of course, be informed by the statutory scheme (see: Fordham, “Judicial Review Handbook” 3ed, at 56.2).
[115] The relevant part of the Commerce Act 1986 is Part 4A. The purpose of this Part is to “promote competition in markets for the long-term benefit of consumers within New Zealand.” (s 1A) Part 4A contains provisions applicable to the electricity industry.
[116] The purpose of Subpart 1 dealing with controlled goods or services is set out in s 57E which is in the following terms:
.. to promote the efficient operation of markets directly related to electricity distribution and transmission services through targeted control for the long- term benefit of consumers by ensuring that suppliers—
(a)are limited in their ability to extract excessive profits; and
(b) face strong incentives to improve efficiency and provide services at a quality that reflects consumer demands; and
(c) share the benefits of efficiency gains with consumers, including through lower prices.
[117] The Commission then has a power, by notice in the Gazette, to declare that all or any goods or services supplied by a large electricity lines business in markets
directly related to electricity distribution and transmission services are controlled (s 57F).
[118]Section 57G sets out the thresholds for declaration of control.
[119]Thresholds can be expressed in quantitative or qualitative terms (s 57G(2)).
[120] Section 57H sets out the process for making decisions on a declaration of control. The Commission must assess large electricity lines businesses against the thresholds set under this Subpart and identify any large electricity lines business that breaches the thresholds, and then determine whether or not to declare all or any of the goods or services supplied by all or any of the identified large electricity lines businesses to be controlled, taking into account the purpose of this Subpart. In respect of each identified large electricity lines business, the Commission is then to make a control declaration or publish the reasons for not making such a declaration.
[121] The process before a declaration is made is set out in s 57I. Before making any declaration of control under s 57F the Commission must⎯
(a) publish its intention to make a declaration and invite interested persons to give their views on the matter; and
(b) give a reasonable opportunity to interested persons to give those views; and
(c)have regard to those views.
[122] The notice of intention to declare must be published in the Gazette and in any other manner, if any, that the Commission considers appropriate. The notice must specify that the matter relates to the making of a declaration and invite interested persons to give their views on that matter to the Commission and specify the time and manner within which they may do so.
[123]The effect of a declaration of control is set out in s 57J.
[124] In terms of s 57K, the Commission may prioritise its duties under the Subpart.
[125] Any declaration of control under the Subpart expires on the earlier of the expiry date stated in the declaration or the expiry of five years from the date of the declaration (s 57L).
[126] Against that background, it must be the case that the Commission has a broad discretion. Other than the directions as to desired outcomes in s 57E, no specific criteria are set for the Commission to consider. A number of different approaches to achieving the statutory purpose must be open to the Commission. I cannot see how the consideration advanced by the plaintiffs can be a mandatory one in the statutory framework.
[127] If there is a problem with the Commission’s approach I see that as a question of reasonableness rather than as a failure to consider a mandatory relevant consideration.
Unreasonableness
(i)Pleadings
[128]Finally, the final decisions are said to be unreasonable because:
a)The change in the “C2” factor derivation from post-tax to after-tax residual rates of return penalises 13 of 28 electricity lines businesses which pay discounts or rebates to customers. This approach leads to an overstatement of the rate of return and disadvantages any electricity lines businesses that uses this method of setting prices for customers, as opposed to electricity lines businesses which provide returns by way of dividends.
b)No reasonable decision-maker could have derived the “C2” factor without incorporating a tax shield provided by the customer rebates and discounts.
[129]This claim is denied by the Commission.
(ii)The two views
[130] Craig Rice is the Corporate Finance Partner in PwC and he specialises in the energy sector. Mr Rice’s experience is referred to by the Court of Appeal in Cudden & Ors v Rodley (CA 67/99, 31 March 1999) at [17].
[131] Mr Rice describes the failure to recognise the taxation impact of customer discounts and rebates as a “substantive error”. His opinion is that in its approach, the Commission overstates the rate of return and therefore disadvantages any electricity lines business that uses a rebate to set prices. He says that as a result the C2 factor does not correctly reflect the post-tax, pre-rebate methodology adopted for the purposes of deriving the X factors.
[132] He considers that the taxation adjustment used to derive the residual rates of return should incorporate the taxation impact of the customer discounts and rebates, which can be assumed to be 33 percent of the value of customer discounts or rebates in each year.
[133] Mr Rice refers to Dr Gunn’s explanation that the final residual rates of return were calculated by adjusting for tax on the same basis as the disclosed ROI values. The explanation Dr Gunn provides is that the numerator of the disclosed ROI values and the residual rates of return include the same tax adjustment. Mr Rice says that the numerators however differ in their revenue components, and therefore their pre- tax values:
The numerator in the residual rate of return includes 100% of discounts (and rebates) as revenue, and the numerator in the disclosed ROI values includes 0% of the discounts (and rebates) as revenue. It is inconsistent therefore to include the same tax value in the two numerators when the pre-tax positions are different.
[134]That is, Mr Rice explains,
if lines businesses were to retain the income they currently distribute as discounts (and rebates) they would be required to pay tax on that income.
[135] He says this approach is consistent with standard corporate finance practice when assessing residual rates of return to standardise the tax treatment of distributions to stakeholders.
[136] The explanation for the use of the post-tax position is discussed in Meyrick & Associates’ report for the Commission of 19 December 2003. Meyrick notes that the range of ownership types and associated purposes “complicates” assessing the profitability of New Zealand lines businesses. Meyrick suggests that the businesses can be roughly categorised into three groups, commercial businesses issuing dividends for shareholders in the normal way; trusts which offer “dividends” to their consumers/owners in the form of explicit rebates which may take the form of line charge holidays; and, trusts which provide a “return” to their consumers/owners implicitly in the form of lower prices. Meyrick takes the view that this makes assessing profitability against normal commercial criteria such as the rate of return difficult. But, Meyrick says, there is not sufficient information to attempt to adjust for ownership influences. Accordingly, businesses are assessed on the basis of pre- rebate prices:
This is equivalent to treating the explicit trust rebates as a form of dividend to ‘shareholders’. (at 60)
[137] Meyrick & Associates then discussed the approach taken in their initial report towards assessing distributor profitability. That was done on the basis of a “relatively simple” residual rate of return measure obtained by subtracting operating expenses and estimated depreciation from “deemed” revenue (total operating revenue plus AC loss rental revenue received less payment for transmission charges less AC loss rental expense paid to customers). Meyrick referred to the criticisms in submissions at this approach including the criticism that the analysis was conducted on a pre-tax basis whereas other regulatory analysis is conducted on a tax adjusted basis.
[138] Meyrick notes that changes had been made to meet these concerns including a change to the residual rate of return analysis. The change was to deduct an estimate of tax equivalent payments so the return was tax adjusted “in line with other regulatory measures.” The report continued:
The tax equivalent payments deducted are actual taxes paid plus 33 percent of subvention payments plus the tax interest tax shield. Subvention payments are payments from one business entity to another in the same tax group (eg subsidiary to parent company) while the interest tax shield is an adjustment to correct for the tax implications of debt rather than equity funding. Adopting this approach to tax equivalent payments puts the measure on the same basis as other aspects of the Disclosure Data regulations and requirements.
[139] Meyrick explained that the residual rate of return was then ascertained by deducting tax equivalent payments plus the new operating expenditure series plus estimated depreciation (calculated as 4.5 percent of ODV) from the new measure of deemed revenue and dividing the resulting figure by the ODV. The report says that revised treatment,
puts the residual rate of return analysis on a similar basis to other commonly used regulatory measures while retaining its links to and consistency with the MTFP database and analysis. (at 61)
[140] The Commission in its December report similarly refers to the fact that many consumer trust and consumer co-operative owned businesses provide rebates or discounts to their consumers. The Commission noted that these businesses “typically” pay only a small dividend to the trust or co-operative to cover administration expenses. This means that the remainder of the funds are distributed directly to the consumer owners who in some cases are a subset of the entire pool of consumers. The Commission stated:
Applying the price path to such discounted prices could be considered to disadvantage those businesses compared to other distribution businesses. However, PwC (on behalf of 18 distribution businesses) has indicated it favours using posted (i.e. pre-rebate) prices as the basis for notional revenue in the price path threshold.
.. The Commission points out that the comparative analysis of profitabilities has been undertaken on a pre-rebate (and pre-discount) basis, which is consistent with applying the price path threshold to notional revenue based on posted prices. Such an approach is more equitable given that rebates are not necessarily provided to all consumers served by a trust-owned distribution business on a consistent basis. In addition, those businesses that provide implicit discounts to consumers are more likely to be assigned a negative C2 factor. (at p 33)
[141] The Commission took the view that it was more appropriate to compare profitability on a post-tax basis, “given the business-specific implications of different governance and ownership arrangements.” The Commission took the view that
using post-tax comparisons and assigning a negative C2 factor to those businesses consistently earning low returns should “generally” be sufficient to deal with concerns about the ability of businesses to undertake new investment. Where this may not be the case, the Commission said it could weigh up the relevant considerations during a post-breach inquiry.
(iii)Submissions
[142] Mr Wilson says the plaintiffs’ case can be identified in some brief propositions. He uses the example of a discount for early payment of an account. The consequence for the lines business is that its revenue is reduced by the extent to which the consumer gets a discount. The Commission adds back the lost revenue but in doing so, ignores the tax which would have been paid on the foregone revenue. As a result, the post-tax profit of the business is over-stated. The business is therefore wrongly ranked with other lines businesses when comparing post-tax profitability.
[143] The plaintiffs say that the end result is inconsistent with standard corporate financial practice and the point is so obvious that to conclude otherwise is irrational. Hence, like cases are not being treated alike. Accordingly, it is submitted that the Commission’s decision is unreasonable in a Wednesbury sense.
[144] The plaintiffs rely on Craig Rice’s opinion that the Commission has erred and the fact that the Commission has not produced an affidavit from Dr Lawrence or any other expert challenging that view.
[145] The plaintiffs reject the notion that there is some dichotomy between the accountancy and the economic approaches. Mr Wilson for the plaintiff points out that NERA are economic consultants as are Charles River. Margaret Beardow is an economist and these are economists they rely on. PwC also now include accountancy expertise but are well known to provide a wide range of services. Mr Rice has had an extensive involvement in regulatory matters. In this context, Mr Wilson submits that there is no proper basis for the Commission’s challenge to Mr Rice’s impartiality. It is acknowledged that Mr Rice expressed his views firmly
but that was because he regarded the matter as being so clear. While he has a professional association with the plaintiffs, he was aware of the Expert Code.
[146] In support of the submission that the Commission’s approach is unreasonable, the plaintiffs are also critical of the way the Commission treats rebates differently from other business decisions which equally have tax implications. The contrast the plaintiffs make is as to the Commission’s approach to discounts, interest on borrowing, and subvention payments.
[147] In terms of discounts, the plaintiffs say that if a lines business decided to introduce a discount on the price a consumer was otherwise to pay, the Commission would either say this was foregone revenue which is not added back at all or, if it is, then would make an allowance for the tax payable on the revenue foregone. This is an indefensible and hence unreasonable distinction which the Commission has drawn.
[148] As to interest on borrowing, Mr Wilson advanced this submission on the basis that interest on borrowings for capital purposes is deductible for taxation purposes. Mr Dobson for the Commission took a different view on the taxation implications of such interest and so, Mr Wilson said, he could not take that matter much further.
[149] If one company makes a substantial subvention payment, on the Commission’s approach that is added back but the tax is taken into account and so the lines company benefits. However, if a company provides a rebate to its consumers as the plaintiffs do, the Commission’s approach is to make no allowance for the tax payable. It is submitted that the argument for treating a subvention payment in this way cannot be as strong as allowing for the taxation implications of a rebate.
[150] In this context, the plaintiffs also rely on the direction in the Energy Companies Act 1992 that the “principal objective” of an energy company “shall be to operate as a successful business.” (s 36(1)). The directors of an energy company
are to be persons who, “in the opinion of those appointing them”, will assist the company to achieve its principal objective (s 37(1)).
[151] The plaintiffs say that it is no answer to suggest that the price path threshold is just a screening mechanism. That is because any breach of the price path threshold has serious consequences. On the finding of a breach there is:
a)The stigma of being identified publicly as having breached the threshold;
b)The significant cost of having to seek to dissuade the Commission from imposing control; and
c)The uncertainty of not knowing what the Commission might do.
[152] As a result of the change to a post-tax consideration, the plaintiffs say that 11 of the 28 distribution businesses shifted into different C factor groups from their September 2003 position. Two of the plaintiffs shifted C factor groups with the first and fourth plaintiffs being assigned a C factor of plus one percent.
[153] Three of the plaintiffs estimate the reduction in cumulative revenue required to meet a price path threshold based on an overall X factor of two percent as compared to an X factor of one percent. The third plaintiff estimates a cumulative reduction in revenue over the five year regulatory period of up to an additional
$700,000. The fourth plaintiff estimates some $4.1 million and the first plaintiff,
$2.4 million. Accordingly, it cannot be said that the change made is not important to the plaintiffs.
[154] Finally, the plaintiffs say that the inconsistency is made worse because the Commission is using historic figures in its calculations.
[155] The Commission submits that its approach is reasonable and, indeed, better reflects the statutory purpose. That is because this is a better way to compare rates of return. Another way of putting it, the Commission submits, is that it is difficult to rationalise pricing if a distribution business has the luxury of rebates.
[156] As to the plaintiffs’ illustration which compares the treatment of a discount for prompt payment to that of the rebate, the Commission says the plaintiffs are not comparing like with like. That is because the discount for early payment does not become part of revenue. Rather, rebates are a form of return to the owners of a business paid out of excess of revenue received over expenses incurred.
[157] Next, the Commission submits that the change to a post-tax position was supported by a number of submissions. Particular reference is made to Charles River Associates who submitted on behalf of Vector that:
a)The way in which the Commission determined return on investment (ROI) was “ultimately a judgment that is squarely of the Commission’s”;
b)Comparability between rebating investor-owned businesses is improved by a post-tax approach; and
c)Economists and accountants may take different approaches to determining rates of return.
[158] The Commission does not contest Mr Rice’s view as a matter of business accounting but rather says that there is room for a different approach where the focus is on economic regulation. In economic terms, when the goal is to compare two businesses, the focus is on the money available out of revenue. Greater transparency is achieved by not adopting the accounting convention relied on by Mr Rice. Indeed, in economic terms, it is the cash outcome which is most important.
[159] In this context, the Commission is critical of the absolutist terms in which Mr Rice’s view is expressed. Mr Dobson argues that the plaintiff’s case on unreasonableness rests on Mr Rice. Mr Rice and other members of PwC were engaged as advocates throughout the whole process. Mr Dobson is similarly critical of the inclusion in Mr Rice’s evidence of factual material about his personal involvement. Finally, it is noted that Mr Rice is an accountant doing corporate finance work and specialising in energy. Mr Rice claims no expertise in economics
but in each paragraph of his evidence is expressing a firm opinion contrary to the Commission explicitly because the Commission’s approach is contrary to that which would be followed by an accountant.
[160] As to the approach to other aspects such as subvention payments, the Commission submits that its approach is not inconsistent. Discounts can never become part of revenue. It is further submitted that each category of expense has to be dealt with in the economic framework in which it is being considered. In terms of interest on capital, in an economic sense, it is submitted that the business has incurred that cost. Hence, this is a cost to the business as opposed to the tax treatment of rebates because the taxation rule suggests that these payments cannot be deducted.
[161] In terms of the subvention payments, Mr Dobson points out that there are only a small number of them. In the total industry there was a maximum of
$6 million of such payments in 2001. In this context, the Commission submits that overall efficiency and tax efficiency have to be distinguished.
[162] In any event, it is submitted that there is at least a basis for the Commission’s approach.
[163] Further, if there is a deficiency in the approach, the Commission argues that it is not so significant as to warrant the Court’s intervention. In that context, the Commission does not accept the submission made by the plaintiffs as to the significance of a breach of the threshold. The Commission also makes the point that this is only one part of the jigsaw. Overall, the final decisions resulted in X factors that do not restrain the plaintiffs’ prices as much as the Commission’s September 2002 draft decisions would have done. The relevant analysis supporting this submission is set out in Appendix B to this decision. Further, the Commission argues that on PwC’s calculations, the plaintiffs would have remained in the group of businesses earning a higher return.
[164] Hence, overall, it is submitted the Commission’s approach represents a modest intrusion. In international terms, Mr Dobson argued this was a “light-
handed” form of regulation. The Commission was dealing with a group of businesses who were unusually disparate in terms of their ownership and so it was the regulator’s challenge not to enter into the fray too much.
[165] Finally, the Commission submits that the notion of any inconsistency as between lines businesses is a flawed one. That is because the lines businesses are all natural monopolies. They do not compete with one another at all and so in this sense the comparative position with other lines businesses does not matter. The Commission argues that it cannot matter if a business meets that point earlier or later than a company which is not a rebater.
(iv)Discussion
[166] In assessing the reasonableness of the Commission’s approach, it is relevant that the Commission’s mandate is a broad one. Further, there is a nexus between the Commission’s approach and the statutory purpose. In terms of creating incentives to keep prices lower and/or create efficiencies, it must be relevant to consider how much revenue remains available to the business after expenses. To proceed on a different basis treats a rebating business as if it has paid taxes when in fact it has not.
[167] In addition, there is Ms Rebstock’s view that some attention has to be paid to the overall efficiency of a business, not just to the tax efficiencies. Although Mr Rice takes issue with this, Ms Rebstock is able to refer in support to submitters at the November 2003 conference who acknowledged the wider efficiency concerns and the lack of transparency of rebates. An example Ms Rebstock gives is the following from Mike Underhill from WEL Networks:
Now the view we have is this: That for a price you post the price and you make it public and you say, going forward until another change this is what the price is and here are the components. For a discount you do the same thing; ..
As opposed to a rebate, which you generally announce at the end of the period, we had a good year and we would like to announce a rebate of whatever after the event so the customer can’t respond to that but it comes out through a windfall.
Similarly with a line holiday
…
.. the components [of a discount] are announced in advance just like price. So a customer can make a usage decision based on a known pricing arrangement.
A rebate is an after the event, ..
[168] Hence, while it may be standard accounting practice to take into account notional tax paid, there are reasons for the Commission to take a different view.
[169] In that context, I do have some concerns about the extent to which I can rely on the regulatory/accounting dichotomy in the absence of any expert economic/regulatory evidence from the Commission. Further, for example, Ms Beardow from Benchmark Economics on behalf of Powerco is an economist and she supports the plaintiffs’ approach in the discussion at the November 2003 conference albeit the context of her remarks may well be slightly different. On the other hand, the economics advanced on the Commission’s behalf are reasonably obvious as a matter of commonsense. Further, it is clear submitters did see the different ownership structures as raising issues of appropriate comparability. And there are exchanges in the course of the consultation process which support the Commission’s view. For example, there is the debate at the November 2003 conference between Professor Evans from Charles River Associates and Dr Lawrence from Meyrick.
[170] Dr Lawrence refers to Professor Evans’ statement that the residual return measured by Meyrick has no meaning in economics. Dr Lawrence suggests that is a misstatement and that there is “quite a long history” of what is more generally known as the economic rate of return, namely, a measure of revenue minus operating costs minus depreciation “to give you an idea of the ranking of firms in terms of the rate of return they are earning on [their] core business”.
[171]Professor Evans agreed his statement was just a “tad” strong. He continued:
I guess what it does relate to is it was unclear to us the costs that were excluded from this, you know, exactly what they were and their relevance. In that sense, otherwise I agree with you entirely, in fact I said, it was seeking to measure what we would call economic profit.
[172] Mr Rice himself agreed there may be “some logic” in a post-tax approach but that needed fuller consideration. And, in any event, he said the post-tax approach had been incorrectly applied.
[173] On this evidentiary aspect, while the Commission does not put its case on this basis, some weight must be given to the fact the Commission is the expert body charged with this regulatory function. In this sense, I do not see any conflict between the Commission’s role and the provisions of the Energy Companies Act.
[174] The next issue is whether there is a problem in the Commission’s differing approaches to other payments such as subvention payments. Essentially, I accept the Commission’s submissions on this aspect. That is, there are differences between those payments and rebates. In terms of the subvention payments, there is probably also a de minimis argument. Given the nature of the Commission’s role, it does have to make some judgments and the statutory regime does not demand exact science.
[175] Ultimately, I consider the Commission’s approach was a reasonable one. It is certainly not an indefensible position – the issue about appropriate measures of comparability was squarely raised in the consultation process and this is one way of dealing with it. It is relevant to this that the purpose of establishing the thresholds is to set a basis which may justify what the Chairperson of the Commission calls “a close look”. That is not to say breach of the thresholds is without consequence but it is not necessarily linked to control.
[176]For these reasons, the claim based on unreasonableness also fails.
Discretion
[177] It is not necessary then for me to address the question of discretion or the nature of the relief sought. An issue in terms of both discretion and the relief sought is the intertwining elements of the price path threshold. That would make it difficult, at best, to make an order entitling the plaintiffs to discrete treatment on the pre/post tax point. Further, in terms of the relief sought, that included an order requiring the Commission to reconsider its final decisions in accordance with such directions as
the Court may give. If relief had been granted it would not have been appropriate, given the complexity and inter-relationship of the components of the price path threshold, for the Court to direct the Commission as to how the taxation implications were to be considered.
Result
[178]The plaintiffs’ claim accordingly fails.
Costs
[179] The plaintiffs would characterise the matter in category 2B for costs purposes but Mr Wilson was happy to leave this to the Court to decide. The defendant submitted the appropriate category was 3B. While the focus of the case is, in the end, relatively narrow the nature and bulk of the evidence support the defendant’s view. Further, both parties were represented by Queen’s Counsel and the hearing took up nearly two days. In the circumstances, I agree category 3B is the appropriate categorisation. The defendant is accordingly entitled to costs on a category 3B basis together with any reasonable disbursements. The latter are to be determined by the Registrar if necessary.
Ellen France J
Appendix A: Consultation process
Appendix B: Overall comparability September 2003 to December 2003
Counsel/Solicitors:
W M Wilson QC, Wellington, for the Plaintiffs
J Bates, Quigg Partners, Wellington, for the Plaintiffs R A Dobson QC, Wellington, for the Defendant
J S McHerron, Crown Law Office, Wellington, for the Defendant
Appendix A – consultation process
Appendix B – overall comparability September 2003 to December 2003
| September 2003 (illustrative) | December 2003 | |||||||||
| X factor components | B | C1 | C2 | C (C1+C2) | X (B+C1+C2) | B | C1 | C2 | C (C1+C2) | X (B+C1+C2) |
| Business | ~ | 1 | 0 | 1 | 3.6 | 1 | 0 | 1 | 1 | 2 |
| Centralines | ||||||||||
| Counties | ~ = 2.6 | 0 | 1 | 1 | 3.6 | 1 | 0 | 1 | 1 | 2 |
| Electra | ~ = 2.6 | 0 | 0 | 0 | 2.6 | 1 | 0 | 1 | 1 | 2 |
| The Lines Company | ~ = 2.6 | 0 | 0 | 0 | 2.6 | 1 | 0 | 1 | 1 | 2 |
ELECTRA LIMITED And Ors V THE COMMERCE COMMISSION HC WN CIV-2004-485-389 [23 March 2005]
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